FIN 3701 Chapter 5: WACC (Weighted Average )

Cost of Capital Assumption University of Thailand In this chapter, you will learn • Determinations and Calculations of Cost of Capital Components FIN3701 Chapter 5 • Debt Corporate WACC • Preferred (Weighted Average • Common Equity Cost of Capital) • WACC= Weighted Average Cost of Capital

Dr. Chainarin Srinutchasart

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Principles Applied in This Chapter addresses the following 3 questions: • Principle 1: Money Has a Time Value. • Principle 2: There is a Risk-Return Tradeoff. 1. What long-term investments should the firm • Principle 3: Cash Flows Are the Source of engage in? Value. 2. How can the firm raise money for the • Principle 4: Market Prices Reflect Information. required investments? (Alternatives: Bonds, Stocks, Preferred Stocks=what is the • Principle 5: Individuals Respond to appropriate price?) Incentives. 3. How much short-term cash flow does a company need to pay its bills? and how to raise it

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The investment decision

Assets Liabilities & Equity Assets Liabilities & Equity

Current Assets Current Liabilities Current Assets Current Liabilities

Fixed Assets Long-term Debt Fixed Assets Long-term Debt Preferred Stock Preferred Stock Common Equity Common Equity

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1 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

The financing decision The financing decision

Assets Liabilities & Equity Assets Liabilities & Equity

Current Assets Current Liabilities Current Assets Current Liabilities

+ short-term bearing liabilities Fixed Assets Long-term Debt Long-term Debt

Preferred Stock Capital Structure zPreferred Stock Common Equity Common Equity

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Capital components are sources of funding Cost of Capital that come from investors. • For Investors, the on a security Accounts payable, accruals, and deferred is a benefit of investing. taxes are not sources of funding that come from investors, so they are not included in the • For Financial Managers, that same rate of calculation of the cost of capital.(except short- return is a cost of raising funds that are term interest bearing liabilities e.g., note needed to operate the firm. payable) • In other words, the cost of raising funds is the We do adjust for these items when calculating firm’s cost of capital. the cash flows of a project, but not when calculating the cost of capital.

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A Template for Calculating WACC

(1) (2) (3) (4) Market After-tax Source of Value x Cost of = Product of Capital Weights Financing (2) and (3) (Note a) (Note b) (Note c) (Note d)

w x k (1-T) Cost of Debt Debt d d = wd x kd (1-T) w x k Preferred stock ps ps = wps x kps w x k Common equity cs cs = wcs x kcs Sum = 100% WACC

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2 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

Should we focus on before-tax or Cost of Debt after-tax capital costs? • Method 1: Find the bond rating for the • Tax effects associated with financing can be company and use the yield on other bonds incorporated either in capital budgeting cash with a similar rating. flows or in cost of capital. • Method 2: Find the yield on the company’s • Most firms incorporate tax effects in the cost debt (YTM), if it has any. of capital. Therefore, focus on after-tax costs. • Only cost of debt is affected.

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Method 1 • It is a standard practice to estimate the cost of debt using yield to maturity on a portfolio of bonds with similar credit rating and maturity as the firm’s outstanding debt.

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Corporate Bond Spread Tables Corporate Bond Spread Tables

YTMSpread Aaa/AAA = 4.56% + .90%

= 4.46%

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3 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

Corporate Bond Spread Tables Method 2

YTMSpread Baa1/BBB+ = 4.56% +1.70% YTM = 6.26%

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A 15-year, 12% semiannual bond sells Component Cost of Debt for $1,153.72. What’s rd? • Interest is tax deductible, so the after tax (AT) cost of debt is:

0 1 2 30 i = ? r = r (1 - T) ... d AT d BT

-1,153.72 60 60 60 + 1,000 = 10%(1 - 0.40) = 6%.

INPUTS 30 -1153.72 60 1000 N I/YR PV PMT FV

OUTPUT 5.0% x 2 = rd = 10%

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Cost of Preferred Stock The Cost of Preferred Equity (cont.) • Finding the cost of preferred stock is similar to finding the rate of return. Preferred Preferred (Divps) Stock = Preferred Stockholder’s Required Rate of Return Price (Pps) (kps)

Divps kps = Pps

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4 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

The Cost of Preferred Equity (cont.) The Cost of Preferred Equity (cont.)

• Example: Consider the preferred shares of Relay Company that are trading at $25 per Divps share. What will be the cost of preferred kps = equity if these stocks have a par value of $35 P and pay annual dividend of 4%? ps

• kps = $1.40 ÷ $25 = .056 or 5.6%

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Three ways to determine the The Cost of Equity cost of equity, rs: • The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock. This return comes in the form of cash distributions of DCF: rs = D1/P0 + g. and cash proceeds from the sale of the stock.

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Estimating the Growth Rate What’s the DCF cost of equity, rs? Given: D0 = $4.19;P0 = $50; g = 5%. • Use the historical growth rate if you believe the future will be like the past • Use the earnings retention model D1 D0 1  g rs   g   g P0 P0

$4.191.05   0.05 $50  0.088  0.05  13.8%.

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5 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

Estimating the Rate of Growth, g Computing Geometric Average Rate of Return

Geometric Rate of Rate of Rate of 1/n Average = 1 +Return for x 1 + Return for x … x 1 + Return for -1 Return Year 1, rYear 1 Year 2, rYear 2 Year n, rYear n

FV = PV (1+g)^n

Compound average 31 32

Using the retention model to find g

Suppose the company has been earning 15% on equity (ROE = 15%) Growth rate (g): and retaining 35% (dividend payout = 65%), and this situation is expected to g = Retention rate(ROE) continue. g = 0.35(15%) = 5.25%. What’s the expected future g?

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Should we focus on historical costs or marginal (new) costs?

How to Calculate the Weight, The cost of capital is used primarily to WACC make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

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6 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

Example: Historical Weights Determining the Weights for the WACC ASSETS LIABILITIES & EQUITIES Historical (past) vs. Marginal (future) Current Assets 50 million Accounts Payable 10 million • The weights are the percentages of the firm Accruals 10 million Other short-term non- 5 million that will be financed by each component. Wd = 30 / (30 + 5 + 40) interest bearing liability TCL 25 million • If possible, always use the marginal weights Long-term Debt 30 million (but if the firm’s existing capital structure is Wps = 5 / (30 + 5 + 40) TL 55 million optimal and should maintain to the future, Preferred Stocks 5 million you can use the historical weights) for the Wcs = 40 / (30 + 5 + 40) 40 million percentages of the firm that will be financed Common Equities : with the various types of capital. Net Fixed Assets 50 million Common Stocks 10 m. Retained Earning 30 m.

Total Assets 100 million 100 million

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Estimating Weights for the Estimating Weights Capital Structure (Example of Using Market Value of Equity) • It is better to estimate the weights using • Suppose the stock price is $20, there are 3 current market values than current book million shares of stock, the firm has $5 million values. of preferred stock, and $30 million of debt. • If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt. Market Value = $20 x 3 = $60 million

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• Vcs = $20 (3 million) = $60 million. What’s the WACC? If rd = 9%, rps = 10%, rs = 14%, Tax = 40% • Vps = $5 million.

• Vd = $30 million. WACC = w r (1 - T) + w r + w r • Total value = $60 + $5 + $30 = $95 million. d d ps ps ce s • w = $60/$95 = 0.631 cs = 0.316(9%)(0.6)+0.053(10%)+0.631(14%) • wps = $5/$95 = 0.053

• wd = $30/$95 = 0.316 = 1.706% + 0.53% + 8.834%

= 11.07%.

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7 FIN 3701 Chapter 5: WACC (Weighted Average Cost of Capital)

Example of the marginal (new) weights What’s the WACC? If rd = 9%, rps = 10%, rs = 14%, Tax = 40% The Carter Company is considering raising $8 million for plant expansion. Management Estimates using the following mix for financing this project: WACC = wdrd(1 - T) + wpsrps + wcers Debt $4M 50% Common stock $2M 25% = 0.5(9%)(0.6)+0.25(10%)+0.25(14%) Preferred stock $2M 25%

The company’s cost of capital is computed as follows: = 2.7% + 2.5% + 3.5% Source Marginal Weights Cost Weighted Cost Debt 50% 9% 4.5%(BT) Common stock 25% 14% 3.5% = 8.7%. Preferred stock 25% 10% 2.5% 100% 43 44

Reference • Sheridan Titman, Arthur J. Keown, John D. Martin, Financial Management: Principles and Applications(12thed). New Jersey: Pearson & Prentice Hall Inc, 2014.

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